What to Do with Information from the Fed for Trading

Current interest rates and interest-rate trends help determine the current position of the economy within the business cycle and are helpful in trading. Low interest rates are associated with economic troughs, and high rates with economic peaks. In a nutshell, the Fed lowers rates to stimulate economic activity and raises rates to slow it.

But the time lag between the Fed’s activity and any reaction by the economy often is a long one, making the Fed’s monetary policy an imprecise indicator. Nevertheless, you can use interest rates to get a rough idea about the current economic landscape.

Interest-rate reductions that the Fed okays generally are good news for the stock market. And when the Fed tightens its monetary policy by raising interest rates, stocks normally react poorly. Either way, stock markets may not react immediately, and unfortunately, many months can pass before either the stock market or the economy responds in either direction to the Fed’s action.

Although the old stock market saying “three steps and a stumble” doesn’t always hold true, markets do often head lower after the Fed raises rates for the third time.

In short, falling interest rates typically lead to a rising economy and to a market that’s changing from a bear market to a bull market — in other words, a bullish transition. Ultimately, a bullish transition leads to a new bull market. Conversely, rising interest rates sooner or later lead to a market that’s changing from a bull market to a bear market — a bearish transition, and ultimately a bear market.

The problem: No consistent timetable exists that enables you to anticipate when these changes will occur, so you should use interest-rate changes only as a hint that a transition may be coming and wait for an additional confirmation before you act on a trading strategy.